Abstract

Existing auditing literature focuses exclusively on rational incentives of investors, managers, and auditors to demand and supply high audit quality, ignoring the potential effect of behavior bias such as sentiment on audit quality. Investors and managers with high sentiment might pay less attention to audited financial statements in their decisions, which lowers their demand for audit quality. Auditors might lower their supply of audit quality if they share the same sentiment or they expect weaker investor monitoring from high sentiment investors, which could reduce auditors’ perceived litigation, reputation, and regulatory risk. We take advantage of the unique Chinese data on audit inputs because the input-based measures are directly under auditors’ control and less confounded than output-based audit quality measures. We find that high sentiment is associated with lower likelihood of audit adjustments and fewer audit hours, consistent with auditors providing low audit effort when sentiment is high. We also find that high sentiment is associated with lower likelihood of modified audit opinions and higher absolute discretionary accruals, consistent with auditors providing low quality outputs when sentiment is high. Cross-sectional analyses show that the effect of sentiment on audit quality is more pronounced for small audit firms, low regulation risk periods, larger clients, and optimistic sentiment. Finally, we show that the effect of sentiment on the output-based audit quality measures is generalizable to the U.S. Our paper is the first to identify behavior biases as a determinant of the clients’ demand and auditors’ supply of audit quality.

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